Why A Tax On Carbon Can Help Climate Change - And The Economy

I recently read a thought-provoking interview with Harvard professor of economics Dale Jorgenson, “Time To Tax Carbon,” the cover story in the September issue of Harvard Magazine.  In it Jorgenson describes a study that he and several colleagues conducted that concluded that a tax on carbon will help climate change – and the economy.

A carbon tax, essentially a “tax on pollution,” has long been regarded as a potentially effective means of reducing the emission of greenhouse gases, but the concern about it has been its negative economic impact.  Jorgenson contends, as described below, that needn’t be the case.

Full disclosure: I’ve been concerned for years that climate change – with the risks it poses to natural resources, agriculture, supply chains and operational infrastructure – could well be the biggest long-term management issue facing business, and have written about it here.  I know many Forbes readers respectfully disagree with me (and I enjoy receiving your spirited emails from time to time).  On the other hand, I’m not exactly an on-the-fringe tree-hugging environmentalist, but am staunchly pro-business, having spent roughly a quarter century in management for a conservative Fortune 500 life insurance company.  But if one accepts that climate change is an environmental and not political event, an actual observable phenomenon and not some kind of vast perverse multinational hoax, then it’s hard not to be concerned about its impact, and the risks it poses to business.

Sunset in Beijing  (Photo: Wikipedia)

So how can a tax on carbon, long regarded as an economic albatross, actually spur economic growth?  According to Jorgenson, it boils down to the ways the revenues raised by the tax are reinvested in the economy.  But better to tell it in his words than mine.

As he says in the Harvard Magazine interview, “No solution to this massive problem will make everyone happy, so the best outcome will involve striking an optimal balance. A carbon tax may do that because it raises revenue, and thus the additional possibility of redeploying those funds in ways that stimulate economic growth.”

Jorgenson describes what he calls the “double dividend” (also the title of his book on this topic). “So in order to achieve the double dividend – curbing emissions whilesimultaneously achieving economic growth – you have to collect the tax and recycle the revenue.  Then the question is, How do you make use of the revenue?  That’s the subject of Double Dividend.  We considered a wide range of alternatives, and we ended up recommending that it be used for a capital-tax reduction.”

Harvard Magazine asked Jorgenson about the different tax scenarios he and his colleagues considered in their analysis: “You compared four options: reducing capital-tax rates on incomes of businesses and individuals; reducing labor tax (i.e. income tax) rates on individuals; proportionally reducing both capital- and labor-tax rates; and, finally, redistributing tax revenues through lump-sum payments to individuals across the income spectrum.”

Responded Jorgenson: “Yes, exactly right. The reason that reducing capital-tax rates is the most effective type of revenue recycling is that it has the effect of stimulating investment.  In other words, it substitutes capital for the use of energy, as money that is returned to households and businesses in the form of lower capital taxes is used for saving and investment, rather than expenditures on energy.  The idea is to reduce the emissions from the use of energy by raising its cost.  And capital, when deployed in place of energy, makes it possible in fact to improve the performance of the economy.  That’s the basic idea.  You might ask, why doesn’t reducing labor tax (income tax) rates do the same thing?  The answer is that labor-tax reduction affects people’s decision about labor supply – when income taxes are lower, people work more and take less leisure time, and they consume more, too, while saving and investing less, and that turns out to produce a less favorable impact.”

How would a tax on carbon be computed?  In their analysis, Jorgenson and colleagues reviewed tax levels ranging from $10 to $50 per ton.  “That’s a very important issue,” he notes in the Harvard Magazine interview.  “The way economists usually approach it is to ask, ‘What would be the price in an international agreement where everybody in the U.S., in China, in Europe, and so on, had to pay the same price to mitigate carbon pollution?’  The answer has been worked out in great detail by many economists, but probably the most prominent is Bill Nordhaus, (professor of economics) at Yale.  He comes up with a price of about $30, right in the middle of the range of prices that we’ve considered.  That’s optimal for trading off carbon emissions against the growth of the world economy.”

Jorgenson projects that if the U.S. economy were to grow at 2 percent annually, adding the carbon tax and effectively recycling its revenue “would lead to annualized growth in GDP of 2.2 to 2.4 percent.”

It’s a theoretical but attractive argument.  Jorgenson also projects that other industrialized countries could achieve similar gains to those estimated for the U.S., since “carbon taxes (in those countries) have a relatively similar effect.”   He’s currently trying to build support for an international agreement, using this logic as a basis, at a global conference on climate change in Paris in 2015.

Simply put, it’s good when the interests 0f the environment and the economy are aligned.  You can read the full interview with Professor Jorgenson here.